With the Fed heads meeting this week it begs the question: Why are they always surprised about inflation? When they target two percent inflation and miss it by such a wide margin it’s Main Street that pays. Joseph Sternberg of The WSJ writes:
Jerome Powell owes us an explanation. The Federal Reserve chairman this week confirmed what investors already had guessed: Surprisingly persistent inflation is dissuading the Fed from cutting its short-term policy rate as soon and perhaps as quickly as Wall Street had hoped.
It’s the right call. The Fed committed its worst error in 40 years when it acted far too slowly to tame inflation following the pandemic. Its institutional credibility—on which hangs a lot in a fiat-money system—now depends on Mr. Powell’s success in suppressing that inflation.
The problem is that the central bank keeps making new versions of the same old mistake, granted with a better policy outcome this time around. It’s still getting its inflation forecasts badly wrong and then acting on those forecasts in ways that exacerbate confusion in markets and the broader economy.
As recently as December, with consumer-price inflation about 4% and the Fed’s preferred personal-consumption-expenditure inflation rate at around 3% (both excluding food and energy), central-bank officials signaled they were on track for at least three rate cuts this year. They repeated that message only last month. The Fed believed it had set inflation on a permanent glide path toward its 2% target.
The central bank wasn’t merely thinking aloud. These signals about where officials thought inflation was heading and what they thought they’d do about it were part of a deliberate practice of forward guidance. The central bank believes it can talk markets into doing what it wants by telegraphing what the Fed plans to do. Wall Street got the message from the central bank’s quarterly economic projections foretelling those three rate cuts. Ten-year Treasury yields fell below 4% toward the end of last year, from above 5% in October, and equities boomed in expectation.
The common thread running through the Fed’s failure to predict accelerating inflation in 2021 and to track disinflation accurately now is the central bank’s model of the economy—the set of spreadsheets, as it were, that are supposed to help Fed staff economists and leaders understand developments on Main Street.
The primary model, known as FRBUS, is impressive. Central-bank staff can plug some 500 variables into about 170 equations to try to understand how changes to the unemployment rate, household incomes, mortgage rates or myriad other factors might influence economic growth and inflation.
It’s also deeply flawed. FRBUS doesn’t adequately account for the effects of fiscal policy, such as the $10 trillion in cumulative deficit spending since the start of 2020, constituting subsidies and other expenditures Congress and successive administrations pumped into the economy. The model didn’t predict the inflationary consumption explosion of that era, and probably has way overstated the (largely illusory) benefits of government infrastructure spending for future productivity and economic growth. The model chronically misunderstands the labor market, and overestimates the effect of a tight labor market on inflation.
Perversely, the model also assumes that inflation will return to the Fed’s 2% target because people will believe officials when they say inflation will be 2%. If that sounds like circular thinking, it’s because it is. Worse, because the central bank’s models overemphasize the role of everyone’s expectations of future inflation as an input into current inflation, the Fed focuses on shaping those expectations via forward guidance. Yet when that forward guidance is based on an erroneous model of inflation . . . At this point the mind really does start to boggle.
At some point, the central bank will have to explain to the public what it’s been getting wrong here and how it will do better.
Fed officials aren’t blind to some of these deficiencies. But correcting these mistakes is the work of years rather than months. A spreadsheet is merely a mathematical crystallization of a set of beliefs about how an economy works. A new and better Fed spreadsheet will require a new and better Fed understanding of inflation, its causes and cures.
While we wait, Mr. Powell needs to make policy today. What to do? Note here that one of the things that makes the Fed’s broken economic models so embarrassing is that the central bank keeps talking about them. Predictions are central to the Fed’s forward guidance—the press conferences, wordy policy statements and quarterly dot plots about future interest rates by which the Fed seeks to guide financial markets. Were it not for all this forward guidance, we wouldn’t know what the central bank’s models have been erroneously predicting in recent years.
Mr. Powell increasingly acts as if he understands this. One of his achievements over the past year has been to convince markets that concrete new data points such as the recent inflation uptick matter more to the Fed than the often bogus projections spit out by its computers. Yet the Powell Fed still relies on forward guidance to an unhealthy degree, a legacy of the Ben Bernanke and Janet Yellen eras. To adapt the old saw, perhaps if you don’t have something right to say, don’t say anything.
Action Line: If the “smart guys” get it wrong, it’s up to Main Street to clean up the mess. Craft your investment plan accordingly. If you want to talk, let’s talk.
